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There has been much talk lately about the Federal Reserve (Fed) balance sheet and the beginning of a process to “unwind” – or reduce – the total assets held there. Just as the balance sheet has never before been this large, the country has never had to reduce such a balance in the past.
As with any company or bank, the balance sheet is a list of all assets and liabilities held by the federal government. Assets are anything owned by the Fed and mainly consist of government securities, mortgage-backed securities and loans made to member banks. Liabilities are the items and amounts that are held in reserve for other institutions, such as banks and the U.S. Treasury.
Quite simply, the Fed prints more money to pay for the asset. The Fed is unique in the fact that it can simply print more money when needed for an item, as long as an asset of the same value is added to the balance sheet.
A liability is any monetary asset that is not in the Fed’s possession. The cash in your wallet? That’s a liability. Money in accounts that banks hold at the Fed? Also liabilities. These items can be exchanged for assets at any time, and the Fed has no control over when or how this would occur.
Theoretically, no. The balance sheet expanded greatly after the 2007-2008 financial crisis, when then-Fed Chair Ben Bernanke led an effort to help keep the economy from sinking into a full depression. The Fed began purchasing U.S. Treasury securities and U.S. agency mortgage-backed securities to directly reduce risk premiums in those underlying securities while indirectly increasing market values in the surrounding credit and equity markets. On Aug. 1, 2007, the Fed balance sheet was $858 billion. By the end of 2009, it had increased to $2.24 trillion. It continued to grow under current Fed Chair Janet Yellen through Oct. 29, 2014, when it hit $4.48 trillion and Yellen ended the bond-buying program. It has been consistently around $4.5 trillion since. Although a huge expansion, many credit the Fed’s actions with putting the markets back on track.
Many economists believe efforts taken by the Federal Reserve to lower interest rates and increase its balance sheet ultimately helped keep the economy from falling into a depression.
Yellen has been clear that she didn’t believe the Fed should start to draw down the balance sheet until there were clear signs the U.S. economy was recovering and could stand the additional inflows. If the assets were reduced too aggressively, pressure could be placed on the bond market because of a reduction in demand for U.S. Treasury securities. This in turn could cause interest rates to increase rapidly, and could spark volatility in the markets.
After testing the markets with four rate increases beginning in December 2015, the Fed determined the market was strong enough to handle the drawdown. The process began in October 2017 and will continue at a measured pace (estimates are around three years) until the balance sheet is at approximately $2.5 trillion, barring any major volatility in the markets.
In the past, the balance sheet was kept at a standard level by re-purchasing maturing securities. As an example, if the Fed purchased two-year Treasury notes, it would invest in more two-year Treasury notes when they matured.
Now, however, as Treasury notes and other securities mature, the Fed is allowing an increasing portion of them to fall off the balance sheet. That increases the amount of securities available on the general markets because the Fed isn’t purchasing a set allotment any longer.
The Fed is not selling off the balance sheet as there will be no asset sales. When Bernanke announced in May 2013 that the Fed at some point might stop purchasing Treasury securities as one of the first steps in ending the quantitative easing process, bond markets panicked with a large sell-off and a spike in interest rates. This event came to be known as the “taper tantrum.” The current Fed has a plan to methodically reduce the amount of purchases each month using a process it said it hoped would be as exciting and uneventful as “watching paint dry.” At some point, however, interest rates could rise because there is more pressure on the market from the reduced participation of the Fed in purchasing both U.S. Treasury securities and U.S. agency mortgage-backed securities.
It is possible you could feel the effects of the drawdown in several ways. If it is done too quickly, interest rates could spike, which could affect items such as your credit card bills and adjustable mortgages.
The volatility could also cause bond yields to rise and stock prices to sink.
If the volatility is too significant, there is the possibility it could lead to a bear stock market or even a recession. Balancing these risks while continuing to slowly increase interest rates is a delicate process for the Fed, and it deserves to be watched closely.
Despite these possibilities, the Ivy Investments team sees little risk in the approach adopted by the Fed for the balance sheet drawdown. The Fed has taken into consideration prior concerns, and has been communicating this change for months in advance of enactment. We foresee no major surprises or issues on the horizon.
Past performance is not a guarantee of future results. The opinions expressed are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through December 2017, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.
Investment return and principal value will fluctuate, and it is possible to lose money by investing. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the fund may fall as interest rates rise.